Compensation - Part 2 - General Principles

Last  Friday, we began a series on compensation costs for personal services. This will be a lengthy series because the compensation cost principle is a lengthy cost principle. Today, we will discuss Paragraph (a) of FAR 31.205-6, which is simply labeled "General".

The very first sentence of the FAR cost principle tells us that there is going to be some limitations to the compensation that can be charged to Government contracts. It states, "Compensation for personal services is allowable subject to the following criteria and additional requirements contained in other parts of this cost principle". The criteria and additional requirements contained elsewhere in this cost principle are many and varied.

The first criteria states that compensation must be for work performed by the employee in the current year and must not represent a retroactive adjustment of prior years' salaries or wages. There are two main points here. First, compensation must be for work performed by the employee. There have been many cases over the years where the Government will find so-called employees on the payroll who perform no or very limited services, and take exception to their salaries. Those salaries were not for work performed. The second aspect of this criteria is that the work must be performed in the current year. Sometimes, especially at small businesses and start-up businesses, shortages of working capital cause the owners to defer payment to themselves. When they try to make it up in a subsequent year, the costs are found to be unallowable because the costs were not payments for work performed in the current year (however, some forms of deferred compensation are allowable and we will be discussing deferred compensation later in this series).

The second criteria states that compensation must be reasonable for the work performed. This might seem rather obvious but many contractors find themselves in a position of having to prove that their compensation levels are reasonable. We will leave the subject of determining reasonableness for another day.

The third criteria states that the compensation must be based upon and conform to the terms and conditions of the contractor's established compensation plan or practice followed so consistently as to imply, in effect, an agreement to make payment. Large companies are likely to have formal compensation plans while small companies are going to rely on consistent practices. A key point here is that proposals to the Government must be consistent with a contractor's practices.

The fourth criteria lays the responsibility for proving reasonableness squarely on the contractor. It states that "no presumption of allowability will exist where the contractor introduces major revisions of existing compensation plans or new plans and the contractor has not provided the cognizant ACO, either before implementation or within a reasonable period after it, an opportunity to review the allowability of the charges." In other words, the Government must pre-approve major changes to compensation plans prior to (or soon after) their effective dates.

The fifth criteria simply states that costs considered unallowable under other cost principles are not allowable under the compensation cost principle merely because the contractor wants to label them "compensation".

Finally, the sixth criteria in this "general" discussion of compensation costs calls out certain individuals who "give rise to the need for special consideration. These individuals include owners of closely held corporations, members of limited liability companies, partners, sole proprietors, or members of their immediate families and  persons who are contractually committed to acquire a substantial financial interest in the contractor's enterprise. These "special considerations" include compensation levels that are reasonable for the personal services rendered and not be a distribution of profits. This "distribution of profits" is a real thorny issue with the Government because profits are not allowable contract costs.

Next: Section (b) - Reasonableness